Until two or three years ago, short sales “negotiation” was the purview of a small niche of real estate agents, attorneys and investors. Depending upon the particular market, real estate agents advise me that anywhere from 30–50% of the properties on the market (which includes properties which are not on the MLS) at any given time may be short sale properties. Accordingly, short sales “negotiations” – and how they are paid – have become a very hot topic involving tens, if not hundreds, of thousands of California homeowners and real estate professionals a year.
Disclaimers: Once again, this is a long article that could be even longer. With so much discussion, I’m not including as many citations as I’d like to. Also, this is education and personal opinion. It does not create an attorney-client relationship nor does it constitute a legal opinion upon which the reader is intended to rely. Please properly retain the author or properly licensed attorney in your jurisdiction to apply these concepts to particular circumstances.
Although this article discusses California, the principles likely apply to most States.
The California Department of Real Estate issued an “Update to DRE Issued Consumer and Industry Alert(s) Regarding Short Sales Fraud, and Related Issues” dated September 16, 2010 (the “September Alert”). DRE releases are common topics on this site. They often create more questions and confusion than they resolve. This results largely from the difficulty of trying to apply legal and ethical concepts that developed regarding positive-equity properties to negative equity transactions.
When one moves from the realm of positive-equity properties to the world of negative equity, an entirely new paradigm of thinking is called for. Sometimes, this paradigm shift might even escape the regulators responsible for policing real estate licensees and should-be licensees. As in any paradigm shift, the terrain is more difficult to navigate, but it is not impossible for those who are willing to pursue the new and higher level of skill required.
The ultimate conclusion from my reading of the Update is that the vast majority of the issues raised can be resolved by proper advice, disclosure and consent. The Update seems to assume that someone (generally the listing agent) is trying to hide something or pull a “fast one” on someone else. If the roles, relationships and methods of compensation of the listing agent, buyer’s agent, and short sale negotiator are disclosed to the seller, buyer and discounting lien holder(s), then it is difficult to see how any mutually agreeable arrangement would be improper.
The Shifting Currents of Negative Equity
The concept of “highest and best offer,” for example, is far simpler to handle in the realm of positive equity where the seller enjoys the fruits of the sale. This involves a qualitative judgment the seller exercises by weighing the value of the offer versus the quality of the offer. Classic real estate analysis assumes that a seller wants the highest price that has the higher likelihood of closing in a short time. Under this assumption, a seller would likely consider a $200,000 cash offer with verifiable funds scheduled to close in 30 days without any contingencies as superior to a $225,000 offer from a buyer requiring financing with a low down payment who needs to close the sale to their current home and scheduled 90 days out. The validity of this analysis varies with the circumstances of the seller and the seller’s time value of money, but makes sense for a hypothetical “typical” seller.
In the realm of negative equity, the concept of “highest and best offer” might have no significance at all. In every short sale I’ve heard of, the lien holder(s) prohibit the seller from receiving any sales proceeds. Accordingly, the seller may be far less motivated to obtain a high price.
Two factors are the likely concerns of a knowledgeable seller: the risk of deficiency liability (personal liability for the discount the lien holder(s) agree to accept) and potential income tax liability for discharge of indebtedness under Internal Revenue Code (IRC) section 61(a)(12) [often referred to as "cancellation of debt income" or "CODI"]. In California and other “non-recourse” States, there are times when these are non-issues.
In California, a purchase money loan secured by a deed of trust or mortgage on a 1 to 4 unit dwelling purchased and used as the borrower’s principal residence is “non-recourse” debt (not subject to personal liability of the debtor; only recourse is to the property). Under IRC 108(d)(1)(A), cancellation of debt income applies only to debt “for which the taxpayer is liable.” It does not apply to non-recourse debt. Hence, a purchase money loan does not subject the seller to either personal liability nor to cancellation of debt income, so the seller likely does not care how high the price is. This extracts “highest and best offer” from the seller’s equation when the only debt is non-recourse indebtedness.
A seller subject to recourse debt will need to evaluate a potential trade-off of deficiency liability versus tax liability. Short sale negotiators report that some recourse lien holders waive deficiency as a matter of course, while others will waive deficiency liability in exchange for slightly higher net proceeds. If one assumes an effective income tax rate of somewhere around 25% to 33%, a waiver of deficiency liability saves the seller a net of 75% to 67% of the deficiency after the tax liability. Moreover, the insolvency exception under IRC 108(a) may further reduce, or eliminate, the CODI as the price of the property declines.
Bottom Line: The “highest” price is not necessarily the “best” price from the seller’s perspective. There are more factors to analyze which have been inadequately recognized in DRE releases.
Understanding the Basics of “Agency”
A real estate “agent” is called such due to the “law of agency,” an ancient common law body of principles originating in medieval England. There are two parties to an agency relationship: the “principal” and the “agent.” In general, an “agent” is a person who is authorized to act on behalf of another (the “principal”) and represent their interest. An agent has a “fiduciary duty” to its principal. This duty is one of the highest level of good faith, trust and loyalty in which the agent places the interests of the principal ahead of the interests of the agent. Nevertheless, the agent does not substitute its judgment for that of the principal. The principal remains the primary actor and holds all decision making authority. Accordingly, the agent is a custodian of the principal’s interests, not a paternalistic substitute for the principal (assuming a principal who is a legally competent adult).
In the California licensing scheme, the licensed real estate “broker” is actually the primary “agent” while a licensed “salesperson” acts subsidiary to the broker and does not subsist on its own. A licensed salesperson is typically referred to as a “real estate agent.” For purposes of this article, I will use “agent” to mean the individual salesperson or broker who is representing a buyer or seller in a sale of real estate, unless stated otherwise in context. California also allows circumstances of “dual agency” in which an agent represents both the buyer and seller upon appropriate disclosures and consents.
A difficulty I have with many commentators and regulators in residential real estate is that their perspective comes across as acting superior to the principal. The principal is not acknowledged as a legal adult who is to be advised and then makes their own decision, but as a child who must be supervised and not allowed to make independent decisions. The agent or the regulator seems to assume the role of decision maker for the principal. In my opinion, the DRE September Alert does not clearly acknowledge the principal’s decision making authority.
A listing agent’s duty to negotiate short sale discounts?
The seller’s agent is commonly referred to as the “listing agent.” A buyer’s agent is typically referred to as the “buyer’s agent” (or sometimes the “selling agent” because they are the one who makes the sale happen). In short sales, someone needs to communicate with the bank to ascertain the acceptable discount. This role gets the common misnomer of “short sale negotiator” or SSN. I consider this a misnomer because many bank loss mitigators don’t negotiate, they merely dictate the discount.
DRE says the September Update arose primarily due to the “growing, questionable, and sometimes unlawful practice of short sale negotiators (“SSN”) requiring/compelling Buyers to pay the SSN’s fee.” [Emphasis added.] Based on the comments and questions I’ve received since this Update came out, many readers are missing the “sometimes” and are failing to distinguish between the unlawful and lawful practices.
The Update is an advisory release from the DRE. Unlike other releases this year, it does not attribute the Update to any particular author or DRE official. As an “Update” it presumably reflects the direction of enforcement or investigative activity of the DRE but it has not gone through the process necessary to create binding regulations and certainly is not new legislation adopted by the Legislature.
I perceive an undertone in the September Update which implies, but does not implicitly state, that the listing agent is responsible to negotiate the short sale discounted payoffs on behalf of the seller as part of the sales commission. I make this inference due to the numerous references opposing a separately stated SSN fee and role of an independent SSN. This is admittedly a personal inference, which the reader might also grow to share as the Update is analyzed below.
If DRE is subtly implying this duty and the lack of additional compensation, where does this duty come from at law?
DRE holds the position that the SSN must be a licensed real estate broker (or salesperson acting under a broker) to negotiate short sale discounts, unless exempt “under very narrow statutory exemptions.” (See footnote 1 on page 1 of the Update.) While I have discussed this in depth in webinars and live speaking engagements, space limits me to quick points in this article.
DRE seems to rely primarily upon Cal. Business and Professions Code 10131, particularly 10131(d). When parsing the applicable verbiage from the statute with my emphasis, I summarize the basis for authority as: A real estate broker . . . is a person who . . . for a compensation . . . does or negotiates to do one or more of the following acts for another or others: (d) Solicits borrowers or lenders for or negotiates loans . . . or performs services for borrowers or lenders or note owners in connection with loans secured . . . by liens on real property.”
In order to require licensing as a real estate broker, the specified actions must be performed “for compensation” and “for another.” If there is no compensation for the person performing the actions or if the actions are not “for another” but are for the person acting, then a license is not required. The Update is largely about SSN compensation, so the compensation issue is a given here. However, there are short sale “negotiators” who are an owner of a company which is buying the property. In that case, they are not compensated by a fee, are not acting “for another,” and do not need to be licensed.
At a core level, one can wonder whether Section 10131(d) even applies to ascertaining the amount of the payoff a lien holder is willing to accept. “Negotiating loans” has historically been applied to loan origination. Recently, it has been extended by application of DRE to loan modification services which may result in changing the periodic payment amount, interest rate, number of payments and/or due date. Recently, DRE has sought to extend it by interpretation to ascertaining the payoff amount of a loan. I doubt that interpretation can be supported in the legislative intent when the statute was debated and approved. Moreover, there is a separate field of “debt settlement” that is licensed in several jurisdictions regarding discounting of loan payoffs. For the purposes of this article, I’m not going to argue whether the DRE conclusion requiring licensing is sound or would be upheld in contested litigation.
Does ascertaining a payoff amount even constitute “negotiation”? This is not a defined term in the statute. Common definitions involve some kind of give-and-take on an interactive basis. “Negotiation” is more than merely transmitting and receiving information. Based on information provided to me from persons handling thousands of short sale communications with loan servicers (banks), there rarely is any “live” or “real time” give and take. The bank’s loss mitigator simply states the bank’s position and has no authority to interact. If a non-licensee is merely conveying and receiving information on the borrower’s side, the non-licensee is not negotiating either. If, at some point, a bank’s loss mitigator is actually authorized to engage in negotiations, then a non-licensed short sale processor should either advise the loss mitigator that the processor can only convey the information to the licensee or the processor can get the licensee or principal on the phone to engage in negotiations.
When a loan servicer uses an Internet short sale portal, such as the “Equator” system used by at least Bank of America and GMAC/Ally, in which there typically is no live interaction, it is hard to imagine how any part of the process constitutes negotiation. It’s simply uploading documents and reading and sending email messages.
One could argue that ascertaining the loan payoff is part of “performing services” for a borrower. But isn’t the buyer at least as interested in the payoff results? In the case of a non-recourse loan (as discussed above), the seller/borrower has no reason to care what the amount of the payoff is. In the end, the seller/borrower’s main (or only) goal is to avoid a foreclosure on his record to reduce the damage to his credit and to be able to re-enter the housing market earlier rather than later. Any successful short sale, regardless of sales price, fulfills this goal.
The buyer, on the other hand, will not close the deal and enjoy the benefits of the property if there is not a sufficient loan discount. This is why investor-buyers have traditionally negotiated the payoffs for their purchases. Since the investor-buyer is negotiating on his own behalf, no license is required.
Anyway, back to the question of a listing agent’s duty.
A listing agent is paid compensation for a sale that closes, typically in the form of a “commission,” which is a percentage of the purchase price. A commission is ordinarily a form of contingent compensation for procuring a buyer who is ready, willing and able to purchase the property. The common 6% “full retail” commission historically does not include the hours and hours that is typically involved to ascertain the short payoff amount(s), if any. Moreover, the skills and knowledge needed to effectively process and “negotiate” short sale payoffs have not been part of traditional real estate training nor part of the licensing examination process. How then could they be considered as part of a listing agent’s “duty” and be folded into a normal commission? The Update doesn’t say.
The DRE position is that “negotiations” must be conducted by a licensee in order for “compensation” to be legally paid. But “compensation” is not synonymous with “commission.” A short sale processing fee for the many extra hours involved in ascertaining acceptable discount(s) is a reasonable addition for someone to be paid for lots of extra work. Unfortunately, the input I receive from short sale processors is that the discounting lenders are less frequently approving a processing fee on the seller’s side of the HUD. This leaves the buyer’s side as an area to explore.
Regardless of improvements shortening the time for short sale processing at some banks, licensees and investors continue to report short sale processing times of four to six months as common, with an occasional 4 to 6 week surprise here and there (plus 9 to 12 month deals on the long side). Certainly the buyer is interested in the efficiency and effectiveness of the short sale processor. The DRE Update seems to erroneously assume that only the seller is interested and affected. Since both the seller and the buyer are interested parties, the designation of the short sale processor and the method of compensation properly falls into the realm of negotiation.
Bus. & Prof. Code Sections 10147.5 and 10176(g) require the listing agreement to disclose that the amount of real estate commission is not fixed by law and may be negotiable between the seller and the broker. Moreover, the listing agreement cannot have the rate of commission pre-printed and any compensation to be received by the broker must be fully disclosed. If the listing agent is going to be compensated for short sale processing (which is a service in addition to the marketing covered by the commission), then this compensation appears to be subject to negotiation. More on this below.
Civil Code Sections 2079.13 to 2079.24 require extensive disclosures about the definitions, duties, and obligations of licensees in roles of listing agent, buyer’s agent and dual agent. The “agency disclosure” must be signed by the buyer and the seller. The purchase agreement forms promulgated by the California Association of Realtors now include agency disclosures on the first page, in addition to the statutory disclosures. However, none of these were written with the idea of a SSN in the transaction.
The SSN might be part of the listing agent’s office, the buyer’s agent’s office, or part of an independent brokerage or law office. An argument can be made that non-licensed short sale processors who do not engage in “negotiations” can provide document handling, clerical and administrative support on an outsourced basis as well. Since these functions were not considered when the legislation was adopted or when the forms were drafted, they now need to be incorporated into a new set of documents. The licensees, servicing personnel and/or buyers and sellers would be well-advised to obtain legal counsel to clarify these increasingly convoluted issues.
The DRE Update (page 3) acknowledges the “muddled and unsettled issue of who the SSN is actually representing,” and that it “is possible that an SSN might fall entirely outside the scope of the statutory agency disclosure law which generally pertains to Listing Agents . . . and Selling Agents.”
The Update acknowledges that attorneys acting in that capacity as negotiators are not only exempt from real estate licensing (see B&P Sec. 10133(a)(3)), but “California lawyers performing legal work and rendering services in the course of their legal practice are not included in the above-identified disclosure law” (page 3). Further, B&P Sec. 10133.2 states that section 10131 does not apply “to any stenographer, bookkeeper, receptionist, telephone operator, or other clerical help in carrying out their functions as such.” This provides an avenue for outsourced processing services to handle non-negotiation functions.
As one likely is sensing, the roles, duties and methods of compensation involved in settling short sale payoffs has virtually unlimited size, shapes, colors and flavors. The necessity is for appropriate definition, disclosure and consent – just the kind of complexity lawyers love because it can create a lot of work.
Highlighting the Update
The Update is a nearly four and a half page single spaced memo which is far too much to be discussing in detail in a blog “article.” Clients can seek a more precise (and, therefore, lengthy) analysis of particular points of concern. At this point, I’ll address only some of the issues or “problems” raised by the Update and offer potential solutions or explanations why the issue is not really a problem.
Problem: The MLS remarks or a pre-sale instruction sheet state that the buyer must agree in advance to pay the SSN’s fee if they intend to present an offer. Offers will not be presented without this. DRE states this is a problem if “the requirement for the Buyer to pay the SSN is being driven by the Listing Agent and/or the SSN, and is really not a requirement of the Seller . . .” This could stifle and limit the presentation of legitimate offers.
Solution: I agree that this is a problem IF the seller does not know about the remarks or term sheet or have an understanding of what is going on. Different approaches can be taken to solve this and they all begin with seller education by the listing agent. The listing agent should have a written discussion of the seller’s options in this respect and a signed consent approving the approach that will be taken. If the seller chooses the approach discussed in the Update with the understanding that it might limit offers and might not be approved by the bank(s), then the seller is entitled to make that choice. Proper documentation is key, including whether the SSN is connected with the listing agent (or is the listing agent) and how compensation will be handled. If I were advising the seller, I would want the listing agent to keep the “Buyer pays” approach as preferred but negotiable. The seller can always include these kinds of terms in a counter-offer and engage in active negotiations regarding them.
Problem: The buyer is told that he or she “must” request a credit for nonrecurring closing costs (“NRCC”), typically 3%, and apply that to pay the SSN fee, and possibly junior lien holders. The NRCC may be shown on the HUD1 but might be paid outside of escrow if not approved by the Lender.
Solution: A short sale package must include a projected HUD1. These likely change through the course of the process. The NRCC and it’s application should simply be shown early enough in the process for proper disclosure to the lien holder which provides sufficient time to object or acquiesce. The payment must then be handled according to the approval or rejection.
Problem: Although the SSN Addendum is a contract document, it is alleged that some SSN’s don’t send it to the Seller’s Lender in order to conceal this information. Intentional concealment of a material contract issue may constitute fraud.
Solution: First, the SSN Addendum is a separate addendum because the issues are not covered in standard forms; hence, an addendum is physically and practically necessary. There is nothing nefarious about this. However, the concealment is likely improper because the terms would likely be considered as “material” to the transaction. It simply needs to be sent in to the lender as part of the initial short sale package and “concealment” is avoided.
Problem: Buyers may be asked to pay off the seller’s credit cards debt, the seller’s moving expenses, to buy the seller’s furniture at an inflated price, and to otherwise provide funds for the direct benefit of the seller. These are problematic if not approved by the seller’s lender.
Solution: Generally, I agree. The short payoff letters always state that the seller cannot receive additional compensation or any of the sales proceeds. I agree that the buyer must not pay “an inflated price” for seller’s furniture. However, there should be nothing wrong with actually buying personal property at true “moving sale” prices. This is not disguised sale proceeds when it is comparable to what the sellers are otherwise receiving from an actual moving sale.
Problem: Including the SSN fee on a HUD1 is “arguably not sufficient to qualify as a realistic, timely disclosure” to seller’s lender that such a payment will be made and may violate the amount of commission approved by the lender.
Solution: First, I disagree with DRE’s characterization of any kind of short sale processing or negotiation fee as a “commission.” As stated above, “commission” is for procuring the sale and should be properly identified as commission on the appropriate lines of the HUD1. The short sale processing fee is for additional services and should be properly identified as such. This is particularly true when short sale processing or negotiations is provided by a third brokerage, an attorney, or a limited scope of duty (clerical/administrative) third party processor. There is no basis for considering these services as ”commission.” They were not part of procuring the buyer. Secondly, the feedback I receive is that banks closely review HUD1 forms. They often identify negotiation fees and reject them. The “final” HUD must be approved by the bank prior to closing and must agree with the negotiating HUDs. Hence, it’s unlikely that anyone is “slipping a fast one” by the bank. If there is an impropriety as cited in the Update, then the resulting consequences are appropriate.
This all goes back to the principles I, and other attorneys I collaborate with such as Jeff Watson, have been advocating since 2008 (probably earlier for Jeff): properly and timely disclose the relevant facts of the transaction to the appropriate participants. Education, disclosure and consent typically overcome the issues raised in the various releases we see from numerous entities in this niche.
Problem: “The SSN Addenda may contain provisions which purport to establish that the SSN (who is negotiating with the Seller’s Lender on behalf of the Seller) is also representing the interests of the Buyer in order to support the rationale given as to why the Buyer is to pay the SSN fee.” This may create issues of unclear agency duties or of insufficiently disclosed dual agency.
Solution: Once again: the standard agency documentation is inadequate for any kind of short sale in my opinion. It was not designed for short sales. I have master forms for my clients which can state that the short sale negotiator or processor is working on behalf of the buyer and not the seller. The seller is advised to seek independent counsel to analyze the resulting outcome. Sometimes the buyer insists upon being the negotiator and is highly experienced in doing so. I cannot emphasize enough the inapplicability (and the lack of existence) of a cookie-cutter approach to handling the roles and compensation for loan payoff discounts. All of the roles need to be properly defined and acknowledged in customized documents. Since both the seller and buyer are interested in the outcome of the short sale processing, the SSN should have a communication system that can keep both of them up to date. Many online processing services provide this feature.
Problem: The lender’s documents might require a seller and/or buyer to certify that the transaction is made at fair market value (FMV) but the listing agents may orally emphasize the payment of “less than FMV as part of a scheme to induce the Buyer to want to pay the SSN fee.”
Solution: The FMV certification will be the topic of an entire article. For now, suffice it to say that, by definition, it is impossible for a short sale to take place at fair market value. The definition of fair market value requires that neither buyer nor seller be under any duress to sell and that unlimited marketing time be available. To the contrary, short sales are distress sales with the seller under pressure to sell. Any lender asking for a FMV certification is asking the impossible and they should know that (as should DRE).
Problems: The Update goes on to discuss further scenarios that involve lack of disclosure, or of consent, or of negotiation between seller or buyer, or settlement payments outside of escrow, or of redirection of funds differently than approved on the HUD-1.
Solutions: The DRE Update generally seems to assume that the respective roles have not been defined, the terms have not been disclosed, and the seller and buyer don’t know what’s going on so they can’t give consent. If any one of these participants were my clients, I wouldn’t want them involved in transactions like that. The solution, though, is simple. Although the verbiage might be extensive, pretty much all of the issues can be resolved by relevant disclosures up front, with consent from buyer and seller, and relevant information provided to the lender(s).
The Update often treats a negotiation or processing fee as a “junk fee” that doesn’t provide real value to a buyer. To the contrary, I have clients who are buyers who negotiate strongly with a seller to assure that the short sale processor or negotiator will be one they (the buyer) select and they offer to pay. This is because the role is critical for the buyer to have a successful deal. I welcome anyone who has “negotiated” a short sale to comment on this article that the process was so simple and quick that they would do it without compensation. No one “in the trenches” would even conceive of that. Compensation for short sale processing or negotiation is not a “junk fee.”
Distinguishing Between “Fraud” and “Commerce”
The Update is fraught with alarming language. It states, “The varieties of fraud continue to evolve” and “fraud purveyors continue to modify their schemes and methods of operation.”
I don’t deny that there is fraud taking place in some short sale transactions. I don’t dispute that many of the examples the DRE Update offers are illegal, or unethical, or improper when not properly disclosed.
I take issue with DRE’s failure to point out that active negotiation of relevant deal points and proper documentation are important catalysts to completing short sale transactions and avoiding more foreclosures. Commerce often requires creative solutions for buyers, sellers and financial institutions. Creative solutions are not problematic or fraudulent when properly disclosed and freely negotiated.
As fear-mongering from regulators, politicians and financial institutions has increased, we are seeing the real estate market enter the double-dip. Transaction levels have declined considerably the last few months. This will be worsened by the revelation of gross improprieties in foreclosure processing by the biggest loan servicers. The impact of banks systematically defrauding borrowers will take some time to be assessed and absorbed by the market.
I have yet to see DRE warn consumers about the widespread fraud consistently perpetrated by the banks.
Real estate licensees, title companies, escrow companies, buyers and sellers are well-served by being made aware of the risks of fraud. However, the world of negative equity has created a new paradigm for which outdated and unprepared analysis do not work. There is a legal quagmire in short sale negotiations and processing that can be confusing. But regulators should not freeze markets or hinder transactions because of the mere risk of confusion. The confusion can be overcome by proper navigation through this quagmire with effectively negotiated and documented transactions. DRE would serve the public well by advising how transactions can be properly structured, not just vaguely pointing out risks without offering solutions other than inaction.
The DRE “Update” can be found at http://bit.ly/DRE0910